Tony Freeman, DTCC Executive Director, Industry Relations
MiFID II will alter the landscape for post-trade processing and will require affected firms to adapt their middle- and back-office activities accordingly. There is still a tremendous amount of work to be done before the industry can claim it is ready for its implementation in January 2018.
Financial market participants are preparing for the January 2018 implementation of the upcoming revision to the Markets in Financial Instruments Directive (MiFID II), which contains many new rules that will dramatically alter the regulatory landscape in Europe.
For example, MiFID II will transform the trading of fixed income and commodities. In the post-trade area, the forced unbundling of trading commissions and research commissions will significantly impact the cost-base of buy-side firms and further reduce revenues for broker-dealers.
Once implemented, MiFID II (and its close relative, MiFIR) will alter the landscape for post-trade processing and will require affected firms to adapt their middle- and back-office activities accordingly.
Related: DTCC's Legal Entity Identifier Service, GMEI Utility, Readies Industry for MIFID II Implementation
MiFID II will impact several areas of post-trade processes; however, the most significant ones that we are focused on are:
1. Derivatives trading: MiFID II will require more over-the-counter (OTC) trading in the derivatives market to shift to trading venues. Significantly enhanced reporting requirements will also increase transparency in derivatives markets – especially in commodities – and bring in new rules whereby asset managers will also be required to report their trades.
2. The adoption of Legal Entity Identifiers (LEIs): From the beginning of 2018, investment firms that are subject to MiFID II transaction reporting obligations should not execute a trade for a client without the existence of an LEI. With only 10 months to go before implementation, worryingly, there is still widespread confusion around how the new model will work.
3. The unbundling of research costs: MiFID II will enforce the unbundling and transparency of payment for sell-side research. Payments for research using execution commission will be defined as an inducement and will be prohibited. MiFID II will therefore enforce strict separation between payment for research and payment for execution commission.
The unbundling of research costs remains an area of concern, with the investment management industry in the EU still trying to reach a consensus on how best to approach this issue. Many of the more complex buy-side firms that hoped to adopt a single operational model to meet MiFID II’s requirements around research unbundling are now finding that this approach may be unrealistic.
The underlying clients (pension funds, insurance funds, mutual funds, hedge funds etc.) may have differing views about commission payment. So a buy-side firm may need to implement two or more models in order to trade under the new regulations.
A new mechanism called Research Payment Accounts (RPA), to replace the existing Commission Sharing Agreements (CSA), is also being created to provide more control and transparency. RPAs are being widely adopted, but many buy-side firms are opting for a simpler, more purist model in which they simply pay for research. As such, RPAs may be a temporary arrangement.
Many firms outside of the EU are also realizing that they will have to consider the unbundling of research costs when trading in European securities or with EU regulated firms. MiFID II is extra-territorial: it affects all those who trade European stocks.
Related: MiFID II Regulations to Impact U.S. Asset Managers
Fixed Income Issues
A more structural issue affects fixed income. Historically, the bond market has traded on a net basis, with no overt commission. The cost of trading is “hidden” within the spread. Most firms will accept that a portion of the spread should be regarded as implied commission.
The consensus of opinion is that this structure will endure – but it is hard to see why this should be the case. Perhaps this expectation is actually a wish. If cost transparency and the avoidance of inducements is the objective then, surely, implied commission cannot persist. It is hard to over-estimate the upheaval this would cause in the market.
Many firms are also under-prepared for the rules around the adoption of LEIs. For example, there is confusion in some brokerage firms where it is believed that trades can continue to be reported at the investment manager (IM) level.
Other firms believe they are also obliged to report who the IM’s underlying clients are. In the latter scenario, there is little agreement on how and when brokers can receive LEIs for both the IM and the underlying clients when accepting orders.
Many firms wish to continue a two-stage process, where the block-trade contains the IM LEI and allocations, which are delivered later, contain the underlying clients’ LEIs. However, even this approach is problematic, as a two-stage process could lead to brokers executing trades and subsequently discovering that an underlying client has a lapsed LEI or even no LEI at all.
The issue of lapsed LEIs has been raised by some industry participants at a recent DTCC forum. With much of the MiFID II focus on the adoption of LEIs, some firms are not enforcing or monitoring whether LEIs are current and have been through the annual review process. Lapsed LEIs currently may be accepted by regulators, but it is not safe to assume they will tolerate this approach in the longer term.
We can see that the industry is still working to reach consensus on how best to implement measures to adopt MiFID II in post-trade areas, such as research unbundling and LEI adoption. The quest for consensus is also evident in the area of international collaboration, where we can see French and UK regulators taking different approaches to complying with MiFID II. At present, the commission unbundling models differ quite substantially.
The extension of the implementation of MiFID II to 2018 was a sign of the exceptional challenges that regulators and market participants would face in complying with the new rules. However, the coming months will provide affected firms with the opportunity to collaborate, question assumptions and move one step closer to setting-up post-trade processes that will help compliance with MiFID II. But as MiFID II is the most radical and wide-ranging shake-up the European markets have ever seen, there is still a tremendous amount of work to be done before the industry can claim it is ready for its implementation in January 2018.
This article first appeared in TabbFORUM on March 23, 2017.